Except for a few hundred of the last 5,000 years of recorded commerce, monetary policy has been an integral market activity. Markets have violently rejected any intervention by prevailing authorities to monopolize this function. Whenever that power was removed from markets—during various civilizational epochs, usually under the pretense of war, or covertly as has been done recently by central banking—the end result has always been money’s losing value.
We need to look no further than the Reserve Bank of India (RBI) that has debased our currency by more than 99% in the last 70-odd years. One can either view it in gold prices, where gold has risen in value from Rs10 per gram to more than Rs1,000 today, or in terms of prices of goods. That this debasement has been slow does not in any way alter the argument that central banking is a one-way ticket to currencies becoming worthless through extended periods of inflation.
But what is the motive? Why should central banks debase currency? For that we need to understand inflation. Any textbook of economics would define inflation as the supply of excess money and credit relative to the goods and services produced, resulting in higher prices. Expansion in money supply is the horse and price increases the cart.
A far more insidious, but less understood, effect of inflation is the transfer of wealth from the late receivers of this expanded money supply to the early receivers. While most monetarists stress the price increase aspect of inflation, it’s Austrian economists who have quite correctly pointed out the real reasons behind inflation. After all, if prices of all asset classes were to increase by the same extent and if the increased money supply were to be distributed through the Angel Gabriel model of the monetarists David Hume or Milton Friedman, nobody would benefit and there would be no incentive to inflate.
But inflation is indeed pervasive and that is because one market constituent (early receivers, i.e., the government) stands to benefit from the process of debasement. In real life, this process of producing new money could be explicit counterfeiting of making brass coins that simulate gold or just printing new money. Whatever the mechanism, it is the early recipients of the new money that get to enjoy the purchasing power of money as well.
It is this covert wealth distribution effect of inflation that is detestable. It’s the reason why governments, the world over, prefer inflation (as opposed to taxation) as a mechanism for raising resources. I am yet to see a central banker with the intellectual integrity to stand up and say that it is not the price of goods that is going up, but the value of money that is falling. The irony is that while central bankers have of late been printing money as if there is no tomorrow, the impression that prevails is of their running a tight ship.
Anyone who has studied some history shouldn’t be surprised. After all, we have granted central bankers the power to print money with impunity and we have also accepted the system in which the very institution that creates inflation in the first place also gets to report on price increases. So, RBI can expand money supply at 24% while at the same time claim that inflation is benign at 3%.
The question, is where are we headed?
The world economic environment today is comparable with the commodity cycles of the 1970s, with the important difference that we have Helicopter Ben instead of Volcker. Paul Volcker recognized the inflationary pressures within the system and raised the interest rates to 22%. Ben Bernanke, on the other hand, responds to inflation with more inflation, i.e., cutting short-term interest rates. This is like throwing petrol on fire and if he continues on that path for a few more years, then we might even witness hyperinflation of the US dollar.
Of late, it has been asked whether the job of a central banker can be automated. The question to be asked is: do we need central bankers at all? Oversight of the banking system is okay. It’s the executive powers to create monetary policy that we object to. The answer, if your goal is sound money, is an emphatic “No”.
We could easily return to a market money system that prevailed before central banks were formed. Whether the money created is backed by gold or silver or lead or even real estate is a decision that can be left to the markets. That, however, would be unthinkable for those still enamoured with central planning. At the very least, we could ensure that central banks stick to a hard currency standard. This can be enforced by making the paper currency exchangeable with the underlying asset at all times.
As in other economic issues, trusting the wisdom of individuals as opposed to collective decision-making of free markets is a folly.
Shanmuganathan N. is director of Benchmark Advisory Services. Comments are welcome at firstname.lastname@example.org